Educational Articles

Coverage Initiation: Dril-Quip Inc.

Brandon B. Cheatham
| December 27, 2010

Dril-Quip (DRQ) recently made its Value Line Investment Survey debut. The company designs, manufactures, sells, and services highly engineered offshore drilling and production equipment that is well-suited for use in deepwater, harsh environments and severe service applications. It also provides installation and reconditioning services, and controls one of the largest fleets of rental running tools that are used for installation and retrieval of deep water equipment. The company’s main headquarters is located in Houston, TX, and it services the rest of the world through its international facilities located in Scotland, Brazil, and Singapore. Dril-Quip was founded in 1981 and incorporated in Texas. After 16 years, it reincorporated in Delaware, and started publicly trading on the NYSE in 1997.

The company generates its revenue from two sources: products and services. Product’s revenue is derived from the sale of offshore drilling and production equipment—the company generates approximately 85 percent of its revenue from this segment. The service segment earns its revenue by providing technical advisory assistance for the installation of the company’s products, reconditioning of these products, or rents running tools for the installation or retrieval of its products. Approximately 15% of Dril’s revenues are generated through the service segment.

The company, however, is in the process of adding three new product lines: subsea control systems, subsea manifolds, and liner hangers. Management expects that these three new products should almost double its potential market size. These growth initiatives should help drive Dril-Quip’s top and bottom lines in the future.

The company’s customer roster is decently diversified. Its top 15 customers account for about 60% of revenues, with the largest customer accounting for only 10%. Moreover, just over half of its revenues come from overseas, which further demonstrates the diversification of its operations.

Dril-Quip has an ongoing contract with a British Petroleum (BP) affiliate to supply wellhead systems for BP’s Gulf of Mexico operations. The company’s wellhead and other undisclosed equipment were used on the Deepwater Horizon well. As a result, the company has been named in at least eight class action lawsuits that seek damages for pollution and loss of revenues as a result of the Horizon Oil Spill. At present, no liability has been accrued in conjunction with these matters, but the process is ongoing, and may not be settled for several years. Investors should remain aware of these potential liabilities, which are hard to quantify since they pose a sizeable risk to the company’s future performance.

Additionally, new regulations have been put in place that increase the complexity of the drilling permit process; this will result in delays for new deepwater wells in the Gulf of Mexico. The company has stated that it is unable to quantify the additional costs related to the moratorium and the subsequent delay in permit issuance, but it is thought to be large because Dril-Quip earns approximately 40% of its worldwide revenues from the Gulf region. Demand for subsea and surface units will likely be pressured because of the additional paper work required to gain drilling approval. The service segment (approximately 5% of revenues) will likely be substantially affected by the new regulations, too. Therefore, the new policies have the potential to greatly pressure the company’s earnings and will likely be something management will have to address head on. These new regulations are expected to pressure earnings in 2011.

The offshore drilling market has seen strong growth in recent years since technology has opened up previously impenetrable depths. The major oil companies have increased capital expenditure levels since the price for oil has increased irregularly over the past several years. Moreover, the world is consuming a tremendous amount of oil, and supplies of easy to drill oil have largely been tapped. As a result, the oil majors are exploring and producing oil at extreme depths, and current oil prices support the economics behind these wells, which once were too expensive to profitably drill. All these factors are positive signs for the offshore drilling segment.

At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.